How Social Security Calculates Income Replacement

Actuaries with the Social Security Administration (SSA) have determined a comparison of benefits relative to wage-indexed career-average earnings is the best approach for calculating income replacement rates.

An actuarial note from the SSA’s Office of the Chief Actuary (OCACT) explains that individuals consulting with financial planners about the income replacement rate generated in retirement by their personal savings or employer-sponsored retirement plans may see replacement rates calculated by comparing benefits to total income (often net of taxes) just before retirement. In contrast, income replacement rates calculated by SSA use a career-average earnings level based on the average of the 35 highest years of wage-indexed earnings.

The OCACT contends financial planners generally work with individuals who have consistent employment and above -average earnings levels. These individuals are usually active full-time employees and are most often at the prime earnings levels of their careers. In addition, employer-sponsored defined benefit plans often calculate benefits (and replacement rates) based on the average of the most-recent, highest-paid five years of employment.

However, in the context of national pensions, career earnings patterns of individuals vary widely. Many have earnings patterns that differ markedly from the patterns of those with stable careers and high compensation (those who are most likely to consult financial planners) or who have long careers at one company and have substantial defined benefit pensions through their employers, the OCACT said. So, for national pensions, the concept of benefit replacement rates requires a different approach to present meaningful analysis for the great variety of career paths represented by workers throughout the economy.

For many workers covered under Social Security, their earnings in the year before benefits eligibility are either zero, due to exit from the labor market, or severely reduced, because of a movement to part-time or lower compensated work late in career. The OCACT finds that 14% of Social Security retired workers newly entitled for benefits in 2008 had no earnings in any of the five years immediately prior to benefit entitlement. Additionally, 46% of these workers had average indexed earnings for the five years prior to benefits entitlement that were less than 70% of their career-average earnings level.

“For the general population, with wide variation in earnings patterns through a career, [comparing benefits to a career-average earnings level based on the average of the 35 highest years of wage-indexed earnings] reflects well the relative standard of living experienced by a worker over a career,” the OCACT concluded.

The complete OCACT analysis is here. The OCACT also provides tables of replacement rates for hypothetical retired workers here.